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Risk parity

Risk Parity, a portfolio allocation strategy balances the overall risk of the portfolio. This approach allocates risk equally to all securities in the portfolio. This strategy allocates less capital to high-risk securities and more capital to low-risk securities. 

For example, consider a portfolio with two stocks A and B.
 

Portfolio = w1 *A + w2 * B

Here, w1 and w2 are the weights to be allocated to A and B. The weights are inversely proportional to their respective standard deviation. Based on this inverse relationship, w1 and w2 can be calculated as follows:
 




Suppose, we have the standard deviations for stock A as 4.50% and for stock B as 1.62%.
 

 


Using the above formulas, the weight allocation to stock A is 26.1% and 75.53% for B.

As you can see less capital is allocated to stock with higher standard deviation, that is high risk and vice-versa.

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